Money, Financial Markets, and Monetary Policy
A Step Toward Neutral
The Federal Open Market Committee kept rates unchanged at the August 7 meeting; the federal funds rate has remained at 5.25 percent since July 2006. While the committee did not change rates, it changed the postmeeting statement to acknowledge that “Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.” Still, the committee maintained that growth is likely to continue at a moderate pace, citing “solid growth in employment and incomes” and “a robust global economy” in support of that view.
The committee acknowledged an increase in the downside risks to growth while maintaining that its “predominant policy concern remains the risk that inflation will fail to moderate as expected.” While the increased discussion of the downside risks to growth was seen by many as a step toward neutral, the implied probability of a rate cut in either September or October actually fell slightly following the meeting. These declines occurred as the probability of no change in both September and October increased.
Judging from the behavior of implied probabilities of federal funds futures, the market had already factored in a possible change in the statement language, since in the weeks leading up to the FOMC meeting, the probability of a rate cut increased. On July 26 the probability that the fed would cut rates in September increased 15 percent, sparked by a particularly disappointing release on new home sales. June new home sales were down 22 percent from June 2006 and 6.6 percent from the previous month. Markets now place nearly a 40 percent probability on the possibility that the Fed will cut rates by the October meeting.
The volatility of financial markets was mentioned in the statement, after the S&P 500 fell almost 6 percent in the slightly over two-week period leading up to the meeting. This decline was primarily influenced by concerns about subprime failures and credit-risk repricing. While the market has undeniably been volatile on a daily basis over the past two weeks, this volatility rapidly disappears when the market is averaged over even a weekly basis. On a weekly basis, the current volatility in the S&P 500 is not particularly different from the movement of the market over the last several years.
Nevertheless, the market bears watching in light of the drop over the last couple of weeks. Large drops in the stock market are correlated with oncoming recessions. As it now stands, the declines have only reversed the gains the market had achieved over the previous two months. However, if these declines were to continue, concerns about a future recession may increase.
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